23 July 2013

Fundamentally Precious

The Technical outlook for Gold is either bullish or bearish depending on your view. But from a Fundamental perspective, the outlook is extraordinary.

The price of Gold has been a roller-coaster for all market participants, regardless of trading motive, duration or trade size – especially since 2008 when USD and commodities volatility rose exponentially. Small retail investors as well as multinational banks have been caught out by the rapid, and often counter-intuitive market moves seen in the Gold market. The horrific one day decline from $1,495 to $1,351 (-9.6%) on April 15th tends to stand out first and foremost for Gold traders.

Spot Gold has halted the sharp declines seen over the past year, correcting from its year-to-date low of $1,180 just three weeks ago. The precious metal is up an impressive 13.1% from its post-Bernanke lows. At this stage, there are probably a lot of frenzied speculators out there busy drawing Fibonacci retracements, studying Moving Averages, RSI and MACD indicators in order to gauge whether Gold is oversold or not - and will it continue lower after a small bounce, or will the precious metal will push on and recover some of the losses made over the course of 2012 and 2013?

From a fundamental perspective however, Gold is entering extraordinary times. For the first time since the Lehman Brothers bankruptcy, the 1 Month Gold Forward Offered (GOFO) rate has turned negative, from 0.015% to -0.065% on July 8th. The 3 month GOFO rate has also fallen below zero – for the first time since 1999. This phenomenon is called backwardation and is a common term used in futures markets – it indicates that the price of Gold for future delivery is lower than the current Spot price. In other words, Gold tomorrow is worth less than Gold today. Before we get into the detail of what this means, its important to set the scene and explain what GOFO rates are in the first place.

What are GOFO (Gold Forward Offered Rates)?

GOFO stands for Gold Forward Offered Rate. These are rates at which owners of Gold are prepared to lend on a swap against US dollars. Quotes are provided in 1, 2, 3, 6 and 12 month time frames.

Who sets GOFO rates?

The contributors are the Market Making Members of the LBMA: The Bank of Nova Scotia–ScotiaMocatta, Barclays Bank Plc, Deutsche Bank AG, HSBC Bank USA London Branch, Goldman Sachs, JP Morgan Chase Bank, Société Générale and UBS AG.

How are GOFO rates calculated?

Each day at 10:30 GMT, all contributors submit their own specific rates to the LBMA. These rates are averaged across all contributors for each time frame and published at 11:00 GMT.

It’s worth bearing in mind that the procedure for setting daily GOFO rates is eerily similar to how LIBOR rates are set each day. Considering that almost all LIBOR contributors were found guilty of market rigging, manipulation and insider collusion – there is a 90%+ probability that the same modus operandi was employed with respect to GOFO rates. A willingness to read between the lines and a smidgeon of intuition is required on this one, which is probably why mainstream media have been slow to admit, cover and analyse the dynamics of modern precious metals markets.

Source:London Bullion Market Association (LBMA) & ZeroHedge

Backwardation suggests a market disconnect between paper prices and physical prices i.e. the spot price of Gold has been falling (despite fiat currency debasement) while the physical price has been rising (despite it being a time of seasonal demand weakness). The rush in to physical Gold continues unabated, regardless of the speculative spot market staying weak. In fact, it’s highly likely that the hullabaloo in the spot/futures/options markets is exacerbating the rise in demand for physical Gold.

For a purely Technical analysis of Gold, click here

The decoupling of the gold futures market from physical delivery indicates that demand for physical delivery now outweighs supply and growing. The effect has intensified in recent weeks which removes doubts that the phenomenon is a statistical anomaly of some sort, but rather, is an indication of an over-leveraged market that is due a correction, or in other words a ‘re-connect’. In our view, backwardation in oil, grain or energy markets can be rationalised, but backwardation in Gold probably indicates a broad lack of confidence in the fiat monetary system being ravaged by central banks around the globe. Demand for Gold is outstripping its supply while the major bullion banks try to artificially cap future prices.

The fundamental backdrop is potentially so daunting that Gold prices will likely see intense volatility for the foreseeable future and increase over time. In the short-term, market activity will ignore the broader fundamental issues and focus on the technical/intra-day market activity combined with broader USD fluctuations. However, in the medium-long term there are a couple of daunting possibilities:

  1. Permanent backwardation whereby the phenomenon becomes the new normal leaving future Gold prices trading at huge discounts to physical delivery. The more market manipulation the bullion banks do, the more paper Gold it will cost to buy physical Gold. Long term, it could lead to Gold hoarding alongside a parallel drop in the use of fiat currency. Bartering may even be the preferred medium of exchange.
  2. Paper Gold prices may reconnect with the physical market in a sharp corrective phase inverse to what we saw over the past year
It’s very difficult to predict what the Gold price will do as all traders know – but what’s more worrying is that the paper market is becoming to a large extent ‘untrustworthy’. The spot price of Gold is no longer reflecting its true value, and there is little investors can do about it aside from invest in physical Gold directly.

Commissioned by Think Forex